Will 2012 Be a Repeat of 2003 and 2009?

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Feb. 6, 2012, 12:01 a.m. EST

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Michael A. Gayed is chief investment strategist at Pension Partners, LLC. , where he helps structure portfolios and develop strategies to maximize the amount of time and capital spent in potentially outperforming investments. Prior to this role, Gayed served as a portfolio manager for a large international investment group, trading long/short investment ideas in an effort to capture excess returns. From 2004 to 2008, Gayed was a strategist at AmeriCap Advisers LLC, a registered investment advisory firm that managed equity portfolios for large institutional clients. In 2007, he launched his own long/short hedge fund, using various trading strategies focused on taking advantage of stock market anomalies. Follow him on Twitter @pensionpartners and YouTube youtube.com/pensionpartners.

By Michael A. Gayed

"I like the dreams of the future better than the history of the past." - Thomas Jefferson

In the latest writing that Marc Faber of the Gloom Boom and Doom Report published of mine, I argued that following the Summer Crash and Fall Melt-Up of last year, market internals seem to be suggesting the strong possibility that inflation expectations are returning to risk-assets.

As followers of my thinking are aware, I deeply believe that identifying conditions is far more important than making predictions. The most important condition that drives the asset-allocation decision is the direction of inflation expectations. If rising, risk-on into stocks. If falling, risk-off into bonds.

Following the first week of January, I noted in my company's free weekly e-newsletter that the ATAC (Accelerated Time And Capital) models we use to manage client accounts were screaming "reflation," allowing us to position aggressively into equities and out of bonds, just in time.

So far so good, but I know there are many who remain skeptical of the rally and are waiting for a pullback. For the skeptics still looking at Europe and the U.S. economy, consider the possibility that the stock market advance is now more stimulative to global growth than anything SuperBen and the League of Extraordinary Bankers can possibly do through low interest rates. Worldwide equity market cap has risen by over $3 trillion in four weeks. Yes, the markets have risen by as much as the entire balance sheet of the Fed and may soon now create more money than the European Central Bank in terms of global liquidity.

For those waiting for a pullback, to me this is akin to the idea of waiting for a pullback following the March 11th low in 2003, and March 9th low in 2009. I made this case in a segment on CNBC recently (which can be viewed at http://video.cnbc.com/gallery/?video=3000070939 ).

Both years were characterized by significant reflation and policy response by global central banks. More so than that, the conditions under which markets began to rally in terms of intermarket relationships are quite similar to today's environment, even with stock prices not having substantially declined beforehand.

I wrote an article on Minyanville ( http://www.minyanville.com/businessmarkets/articles/technical-analysis-market-analysis-market-market/2/1/2012/id/39161 ) in which I argued that it was entirely possible for markets to rally more than 40% this year. I also specifically stated this was not a "call" on markets, but rather that if I'm right regarding the conditions being parallel to the environments that characterized risk assets in 2003 and 2009, markets did move in such a fashion off the lows.

I'm not suggesting that a significant decline can't happen; I'm making the point that the conditions are suggesting this is potentially an environment where a real bull market can occur. And the beginning stages of a real bull market generally don't give people the opportunity to position into a pullback.

Don't judge me on this in thinking I'm a perma-bull or perma-bear if this is the first time you're reading my work. I correctly identified the conditions which resulted in the Summer Crash, Fall Melt-Up and Winter Resolution before they happened. Because markets are driven by probabilities and not certainties, my entire point is that the conditions dictate that the probability of a surprising bull market are higher now than I believe the vast majority of investors estimate.

Emerging Markets -- Vanguard MSCI Emerging Markets ETF /quotes/zigman/1490180/quotes/nls/vwo VWO +1.68%  -- are strongly outperforming, small-caps -- iShares Russell 2000 Index Fund /quotes/zigman/260873/quotes/nls/iwm IWM +2.18%  -- are strongly outperforming, and Treasury Inflation Protected Securities -- iShares Barclays TIPS Bond Fund /quotes/zigman/1484258/quotes/nls/tip TIP -0.84%  -- are strongly outperforming. In other words, the quality of this rally is high and is indicative of a return to risk-taking.

Let's focus on small-caps as an example. Take a look below at the price ratio of the IWM relative to the iShares Trust S&P 500 Index Fund /quotes/zigman/259938/quotes/nls/ivv IVV +1.40% . As a reminder, a rising price ratio means the numerator/IWM is outperforming (up more/down less) the denominator/IVV. A larger version of this chart can be seen at http://www.pensionpartners.com/marketwatch/iwmivv020312large.png .

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When small-cap stocks outperform, it means investors are getting more and more comfortable with risk-taking. After all, small-cap stocks tend to have higher beta, and thus sensitivity to the economic cycle. They also tend to have lower volume, which means if you're a big institutional investor, you have to position in gradually otherwise you affect price.

From a risk-sentiment standpoint, strength in small-cap stocks and the trend in that leadership is a bullish thing for markets. The ratio has nearly undone completely the Summer Crash of 2011 with no signs of stopping just yet.

The bottom line is that market internals are very strong, and with news that Fed futures are starting to anticipate that the Fed will raise interest rates some time in the middle of 2014, we could be at a real reflationary juncture now that is still early on, and that could send risk-assets up substantially into year-end.

Markets have a funny way of rallying with the fewest amount of people participating in it. And given the substantial outflows from stocks last year, it seems to me that there is a lot of new money that at some point can't wait to chase past prices.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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